If you are planning to start a business, it won’t be very long until you have to decide on its structure. A business structure is a legal designation that describes how a company is organized, how it raises capital, its legal obligations, and how much it must pay in taxes.
Choosing the proper business structure from the outset will set your business up for financial success and reduce the chance of messy legal headaches down the line. This article will explore two of the four legally-recognized business structures available to businesses in the US.
- Sole Proprietorship
- Limited Liability Company (LLCs)
- Corporation (S and B corporations)
Most small businesses don’t choose a corporate structure, and partnerships are essentially sole proprietorships between two or more partners, so this article won’t focus on them in detail.
Before we talk about the pros and cons of sole proprietorship and LLCs, let’s get some definitions out of the way.
The sole proprietorship is the simplest yet most legally risky of all business structures. Sole proprietorships are unincorporated and have one owner who collects all the profits and is legally responsible for all debts.
Additionally, sole proprietorships are the default business structure. Unlike the other structures, there is no paperwork you need to fill out to apply to be recognized as a sole proprietor. If you own and operate a business, and you haven’t sought out another type of business structure, then you are legally considered a sole proprietor by default.
When it comes to paying taxes, sole proprietorships practice what is called pass-through taxation. With pass-through taxation, the business itself doesn’t owe taxes on its income. Rather the sole proprietor pays taxes on the business’s income via their personal tax returns.
Notably, sole proprietors are legally identical to their businesses. There is no legal separation between the sole proprietor and the company. If the business fails or assumes heavy debts, the sole proprietor is legally responsible for repayment.
LLCs allow business owners to separate themselves legally from their business. Business owners—called members in this structure—are not legally liable for a business’s debts, nor can their personal assets be seized during bankruptcy. LLCs can be formed by one individual or a group of individuals, and their management structure is mainly up to LLC members.
LLCs are formed at the state level and have pass-through tax obligations by default. However, one of the benefits of an LLC business structure is that members can choose to change the pass-through tax status to corporate taxation. This gives members flexibility in administering their LLC’s finances.
Now that we have working definitions of each, we can explore the ramifications of each’s differences.
As mentioned above, the default business structure is a sole proprietorship. You don’t need to formally declare you are a sole proprietor; simply obtaining your business permits, any zoning permits, or other necessary licenses from your state of operation grants you sole proprietorship over your business.
However, businesses need to jump through a few more hoops to become LLCs. Unsurprisingly, LLCs need business permits, licenses, and other documents required of a sole proprietorship. However, they also need to file a document called the articles of organization (a.k.a. certificate of organization) with their state. This document makes a business its own legal entity.
If more than one person is forming an LLC, its members will need to draft an operating agreement, which outlines the rights, duties, and obligations of an LLC’s members. Though not mandatory in all states, most LLCs with more than one member opt to draft one. More on operating agreements in the next section.
Sole proprietors have total control over their business’s management. They are solely responsible for paying taxes, managing finances, and taking care of other administrative tasks, such as hiring employees, accountants, managers, etc.
As long as the actions of a sole proprietor function within the limits of the law, there are no restrictions on how they run their business.
Members of an LLC have more restrictions on managing the day-to-day operations of their business. Though the breakdown and delegation of responsibilities are primarily up to the founding members of the LLC, once finalized, each member is limited to their specific stake in the company as established by the operating agreement.
The most common way LLCs break down ownership, profits, and responsibilities is based on percentages. Often, the power of a member’s vote depends on their stake percentage in the company. A member who owns 25% of the company has a ¼ vote on important decisions. Likewise, they will receive 25% of the business’s profits.
As detailed above, sole proprietors are responsible for paying their business’s taxes simply because there is no legal separation between them and their business. This is called pass-through taxation, and it is also the default for LLCs. However, LLCs can opt to be taxed according to corporate taxation laws, where the business itself is its own taxable entity.
Sole proprietorships require the least amount of paperwork and annual maintenance to operate. Apart from a business’s tax obligations or industry-specific paperwork requirements, there are no additional hoops sole proprietors need to jump through.
Many states require annual filings from members on behalf of their LLC. In addition to these state requirements, it’s good practice that LLCs members meet semi-regularly and have a structured and documented process for transferring membership units (the term for a member’s stake or shares), adding new members, and dismissing old members.
Though not legally required, these latter suggestions help preserve liability protection for members in the case of bankruptcy or other destructive litigation.
The structure you choose for your business ultimately depends on your financial, legal, and operational requirements. For many small business owners who are the primary employee, a sole proprietorship makes the most sense financially.
However, as multiple owners come into play and your business requires a more complex structure to operate effectively, an LLC quickly becomes the better option.
About the Author
Roni Davis is a writer, blogger, and legal assistant operating out of the greater Philadelphia area. She writes for CMOX, a company that helps connect businesses to part-time CMOs.Clearone Advantage, Credit Associates, Credit 9, Americor Funding, Tripoint Lending, Lendvia, Simple Path Financial, New Start Capital, Point Break Financial, Sagemore Financial, Money Ladder, Advantage Preferred Financial, LoanQuo, Apply.Credit9, Mobilend
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